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Monday, October 17, 2011

You could be forgiven for not knowing it, but economists are meant to be tough on business. Their ideology holds that capitalism is good not because it's good for capitalists, but because it's good for consumers - and consumption is "the sole end and purpose of all production".

So said Adam Smith, who added that "the welfare of the producer ought to be attended to, only so far as it may be necessary for promoting that of the consumer".

The economists' ideology holds that, when markets are working properly, most of the benefit flows to consumers in the form of lower prices and better service, with businesses making no more that "normal" profits (the lowest rate of profit needed to keep the firm's resources employed in its present industry).

Economists should also distinguish between the capitalists (the suppliers of capital - the shareholders) and the managers, who are supposed to be merely the agents of the shareholders who must at all times represent the true interests of the shareholders, never their own interests. Likewise, company directors are supposed to represent the shareholders' interests, not management's interests.

So economists are supposed to be pro-market, not pro-business and certainly not pro-management.

That's how it's supposed to be, but often not the way it is. In practice, economists who work for business aren't free to criticise it in public. The same goes for those who work for conservative governments (or Labor governments anxious to keep on side with business). And few academic economists take an interest in such mundane issues.

But another factor that helps explain the gap between principle and practice is that the economists' basic model recognises no role for collective action, including action by governments. So when things go wrong in markets, economists' first inclination is to defend the market and blame governments.

All this explains why economists have such a poor record in speaking out about excessive executive remuneration - as witness, the Productivity Commission's report on the subject of a few years back. That this is a case of market failure is as plain as a pikestaff, but the commission's economists searched under every rock without finding it.

One honourable exception to this glaring dereliction, however, is Diane Coyle, who tells it as it is in her latest book, The Economics of Enough. As her previous bestsellers attest, Dr Coyle - whose PhD is from Harvard - is a most orthodox economist.

Seeking to explain the origins of the explosion in executive pay, she attributes it to the deregulation of the financial markets in the US, Britain and elsewhere.

"Organised crime aside," she says, "the most ostentatious flaunting of wealth has emanated from the banking sector. As it turns out, these vast earnings and bonuses were undeserved. The bankers [in the US and Britain] ran up large losses, ruined their shareholders, and left taxpayers with the bill. It will be extraordinary if they turn out to have fooled, scared or bullied politicians around the world into stepping back from fundamental reform of the banking sector."

But the key point is the impact such high incomes in banking have had on the rest of society.

"The bonuses far in excess of salaries, and the spending on big houses, fast cars and designer clothes they funded, did create a climate of greed," she says.

"People in other professions who are in reality in the top 1 per cent or even 0.1 per cent of the income distribution were made to feel poor by the bankers.

"Banking bonus culture validated making a lot of money as a life and career goal. It made executives working in other jobs, including not only big corporations but the public sector too, believe that they deserved bonuses.

"Remuneration consultants, a small parasitic group providing a fig leaf justification for high salaries, helped ratchet up the pay and bonus levels throughout the economy.

"The whole merry-go-round of bonuses and performance-related pay is a sham. In almost every occupation and organisation it is almost impossible to identify the contribution made by any individual to profits and performance - complicated modern organisations all depend on teamwork and collective contributions."

So what can be done about it? In late 2009, the British government introduced a penal tax on bonuses above #25,000 in banking. The tax was criticised, not only by bankers but also by others who thought the measure impractical.

"But it was one of the few measures any government has so far taken that was absolutely right. The symbolism is vital even if by itself the measure doesn't bring to an end the corrosive culture of greed. Whatever the practical limitations on their actions, governments can still achieve a lot in symbolic terms, which should never be underestimated when it comes to impact."

And governments could do a lot more to change the social norms that helped destroy the Western financial system. For example, they could halt bonus payments in the public sector altogether, or introduce a general additional tax on non-fixed parts of people's pay packages.

"I am not opposed to people making more money if they studied hard or worked hard for it, or took the risk of setting up a successful new business - on the contrary, effort and entrepreneurship must be rewarded amply," Coyle says.

"Nevertheless, governments have to give a lead in restoring the sense of moral propriety and social connection between those people who are part of the extraordinarily wealthy global elite and the great majority of those with whom they share their own nation.

"Senior bankers should also contribute to this task of making greed and excess socially unacceptable once again." Amen to that.